FOOL ON THE HILL
Are Tech Stocks Safe Yet?

While there are bargains to be had, Whitney Tilson argues that many tech stocks still remain too richly valued for him to consider buying. Investors should look at history and realize that every time it's looked like we've been in a "new era," stock prices have always fallen back to trend, and then some.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Whitney Tilson
February 27, 2001

In last week's column, I noted that six of the most popular tech stocks I warned investors about last October -- Cisco (Nasdaq: CSCO), Oracle (Nasdaq: ORCL), EMC (NYSE: EMC), Sun Microsystems (Nasdaq: SUNW), Nortel Networks (NYSE: NT), and Corning (NYSE: GLW) -- had fallen an average of 51% (now 55%) since then. Does that mean now is a good time to start buying?

While these stocks are all ones I'd like to own at the right price and under the right circumstances, I'm not even close to buying any of them. Nor do I think buying a general basket of tech stocks -- via an exchange-traded fund like the Nasdaq 100 Trust (AMEX: QQQ), for example -- makes sense at this point. Why?

Valuation
I don't think the six stocks noted above are cheap, though at first glance they might appear to be trading at an average future P/E of only 30x, versus 74x last October. (I posted details on each company on the Fool's discussion boards). What a bargain, right? Not really.

First, 30x isn't exactly cheap, though perhaps it might be reasonable for such high-quality companies. But I don't think they're really trading at this multiple because, as I've noted in previous columns, companies like these that issue a blizzard of stock options to employees have compensation expenses that are understated -- which overstates margins and profits. For example, according to estimates in Cisco's 10-K, net income last year would have been 42% lower than reported had the cost of options appeared as compensation.  Reducing Cisco's $0.81 EPS estimate by 42% yields $0.47, suggesting that Cisco is not trading at 32x future earnings -- but 55x.

Don't believe the analysts
And that figure assumes you believe the analysts' forecasts, which I don't. If you need any convincing that most analysts are primarily focused not on serving investors but currying favor with the companies they cover so that they can drum up investment banking business for their employers, consider the following.

Inventories were skyrocketing, upstream and downstream companies were reporting terrible results and -- for example -- Cisco's John Chambers was practically shouting from the rooftops that his company's business was slowing significantly. But did the analysts warn anyone? Nope. They were shocked -- SHOCKED! -- that Cisco missed its EPS number last quarter and warned about the next few quarters. The story was the same across the board, as every one of the companies noted above save Oracle has had a major stumble or issued an earnings warning recently.

And I don't believe the major factors that have caused these companies to stumble -- a slowing economy, massive overcapacity, tremendous excess inventory, and little or no equity or debt financing available to their customers -- are temporary or quickly reversible.  Thus, I think analysts' estimates remain overly optimistic.

Lessons of history
What we experienced in 1999 and early 2000 was the tail end of one of the biggest stock market bubbles in history. Not the overall stock market -- just tech stocks. Nearly everything else was a screaming buy last March. 

The bubble has been bursting for less than a year now. Is it over? The lessons from history are not comforting. On the discussion boards, I've posted some information on the bubbles of 1929 and 1973, which took nearly three and two years to deflate, respectively. Also, consider a study by Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co., cited in the July 3 edition of Outstanding Investor Digest.

In it, Grantham studied 37 examples of bubbles -- defined as 1-in-40-year breakout events -- in stocks, gold, oil, and the like over 200 years. He concluded: "Every one of them -- most of which were felt to be new eras -- gave everything back to trend. There were no survivors." That's scary enough, but consider Grantham's next point: "In the stock market, the subsequent declines never stopped at the trend line. They all went slicing through fair value like a knife through butter."

This brings me to my final point.

Investor psychology
Fueling the historic rise in tech stocks was not only the rapidly rising profits earned by many of the underlying businesses, but the willingness of investors to pay ever-increasing multiples for these profits. As Warren Buffett said in a brilliant and prescient November 1999 article in Fortune:

"Once a bull market gets under way, and once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks. In effect, these people superimpose an I-can't-miss-the-party factor on top of the fundamental factors that drive the market."

It's been fascinating to see how much the typical reaction has changed, over the past year, to my consistent message about the perils of investing in richly valued tech stocks. A year ago, at the peak of the madness, people would send emails mocking me (and Buffett), boasting about how much money they were making trading tech stocks. Last fall, when I wrote three consecutive columns on the dangers of even the "safest" tech stocks, I received a barrage of hate emails because investors had suffered some losses and were frightened. 

The hatred is now gone, replaced by sadness and desperation. It breaks my heart to read emails from people who have lost 50% or more of their life's savings. These aren't day traders, either. They're conservative people who bought the "best" and "safest" stocks like Cisco, WorldCom (Nasdaq: WCOM), Lucent (NYSE: LU), and Nortel.  The important point here, though, is that these investors haven't sold yet. They're terrified to hold on, yet equally terrified to sell. Only when my emails indicate that people have finally given up, sold their tech stocks, and vowed never to buy them again -- the capitulation phase -- will I believe that we have hit the bottom.

How close are we to the bottom?
According to Steven Leuthold of Leuthold/Weeden Capital Management (quoted in The New York Times --- free registration required), "Historically, the median price-earnings ratio for the tech sector is 33x earnings.  Right now we are at about 47x earnings."

Applying that ratio to the Nasdaq would put it at around 1,600. But don't forget Grantham's point about declines not stopping at the trend line.

Should you run out and sell all your tech stocks? It depends, as always, on what you own specifically. As Buffett said, "[Berkshire Hathaway Vice Chairman Charlie Munger] and I never have an opinion on the market because it wouldn't be any good and it might interfere with the opinions we have that are good.... If we find a company we like, the level of the market will not really impact our decisions."

That's the key. If you find a great company within your circle of competence, available at a bargain price, you shouldn't hesitate to buy it based on a negative view of the sector it's in. I'm simply urging you to be aware that both the fundamentals and investor psychology will likely be working against you in the tech space, so don't buy -- or hold -- any tech stock unless you're comfortable with your assessment of its future performance and valuation.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of the companies mentioned in this article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.